CREDIT RATING

Rating implies an assessment or evaluation of a person, property, project or affairs against a

specific yardstick/ benchmark set for the purpose. In credit rating, the objective is to assess/
evaluate a particular credit proposition (which includes investment) on the basis of certain
parameters. The outcome indicates a degree of credit reliability and risk. These are classified
into various degrees according to the yardstick/ benchmark set for each grade. Credit rating
involves both quantitative and qualitative evaluations. While financial analysis covers the
quantitative part, qualitative analysis covers a host of factors such as the firm’s competitive
strength within the industry/ trade, likely effects on the firm’s business of any major
technological changes, regulatory/ legal changes, etc, which are all management factors.

The Basel committee has defined credit rating as a ‘summary indicator’ of the risks
inherent in individual credit, embodying an assessment the risk of loss due to the default
of a counter by considering relevant quantitative and qualitative information. Thus credit
rating is a tool for the measurement or quantification of credit risk.

Key Takeaways

 A credit rating is a quantified assessment of the creditworthiness of a borrower in general

terms or with respect to a financial obligation.
 Credit ratings determine whether a borrower is approved for credit as well as the interest
rate at which it will be repaid.
 A credit rating or score is assigned to any entity that wants to borrow money—an
individual, a corporation, a state or provincial authority, or a sovereign government.
 Credit for individual consumers is rated on a numeric scale
 Bonds issued by businesses and governments are rated by credit agencies on a letter-
based system ranging from AAA to D.

What is credit risk?

Possibility of losses due to

1. Inability or unwillingness of the borrower to pay

a) Principal

b) Interest
on time

2. Increased collection cost

Services provided by credit rating agencies

• Credit rating service
• Research
• Consultancy/ advisory
• Risk management
• Credit education/ training

The need for Credit Risk Rating has arisen due to the following:

1. With dismantling of State control, deregulation, globalisation and allowing things to shape on
the basis of market conditions, Indian Industry and Indian Banking face new risks and
challenges. Competition results in the survival of the fittest. It is therefore necessary to identify
these risks, measure them, monitor and control them.

2. It provides a basis for Credit Risk Pricing i.e. fixation of rate of interest on lending to different
borrowers based on their credit risk rating thereby balancing Risk & Reward for the Bank.

3. The Basel Accord and consequent Reserve Bank of India guidelines requires that the level of
capital required to be maintained by the Bank will be in proportion to the risk of the loan in
Bank's Books for measurement of which proper Credit Risk Rating system is necessary.

4. The credit risk rating can be a Risk Management tool for prospecting fresh borrowers in
addition to monitoring the weaker parameters and taking remedial action.

The Credit Risk Rating method is used by Bank's Credit officers,

* To gather key information about risk areas of a borrower and

* To arrive at a risk score that would reflect the borrower's creditworthiness/degree of risk. an
agenda item.

Process of credit rating:

End Use of Risk-Ratings made on the CRF

Broadly, CRF can be used for the following purposes:

a. Individual credit selection, wherein either a borrower or a particular exposure/ facility is rated
on the CRF.

b. Pricing (credit spread) and specific features of the loan facility. This would largely constitute
transaction-level analysis.

c. Portfolio-level analysis.

d. Surveillance, monitoring and internal MIS

e. Assessing the aggregate risk profile of bank/ lender. These would be relevant for portfolio-level
analysis. For instance, the spread of credit exposures across various CRF categories, the mean and
the standard deviation of losses occurring in each CRF category and the overall migration of
exposures would highlight the aggregated credit-risk for the entire portfolio of the bank.

Impact of Single Most Crucial Factor on Rating

The vetting authority on the basis of the crucial factors mentioned below may downgrade the rating
of an account.
“Effects of any major developments which are not yet cleared, major damage to plant/stocks, court
judgement on environmental threats, involvement of promoters/company in excise/FERA/tax-
evasion, recovery suit/winding-up petition filed by Creditors/FIs/Banks, any civil/criminal
proceedings against the promoters/company, change of management etc.”
OR
Any other crucial factor, which has come to the notice of the bank and has a substantial effect on
the operational efficiency/viability of the unit such as:

a) Affecting willingness/capability of the promoters to repay the debt as per agreed terms
and conditions
b) Substantial impairment in the value of assets (including Block Assets/Loans and
Advances/ Investments, Inventory/Debtors)
c) Obsolescence of the product or any major change in the Govt. Policies having the
substantial impact on the performance of the company etc.

The factors stated above are only indicative and the account may be downgraded on any other
crucial factor, which affects the operating efficiency/viability of the unit.
PARAMETERS AND THEIR DESCRIPTION

QUANTITATIVE PARAMETER

1. Growth in sales
2. Growth in OPBDIT
3. Return On Investment
4. Total Debt Equity Ratio
5. Current Ratio
6. Contingent Liability / Net Worth
7. Debtors Collection
8. Inventory Holding
 9. Debt Service Coverage Ratio
10. Raw Material/ Cost Of Production
11. Gross Profit Margin
12. Product Range
13. Operating Leverage
14. Cash Flow Adequacy

QUALITATIVE PARAMETER
• laid down regulatory framework standard
• experience of top management
• qualification of promoter
• attitude and skills of employees
• technological competence
• honoring financial commitments
• end use of funds
• attitude of customers
• quality of products
• market share
• capacity utilization
• availability of raw materials
• transparency in accounts
• threat from environmental factors
• internal control
• industrial outlook
Importance of Credit Rating. The benefits accrue to various
groups in different forms. The major groups are investors, issuers
and intermediaries.

(i) Investors: The rating provides the investors with an independent,

professional and genuine judgment in the credit quality of the
instrument which the investor would not otherwise be able to
evaluate.
Ratings can be used by the investor to hedge the risk and balance
his return. Large institutional and other investors also make use of
these ratings to make investment decisions.
(ii) Issuers: The issuers of rated securities are expected to have a
wider access to the investors. This stems from the fact that more and
more investors are using rating as a tool for decision-making and
the market protection of the rating. Credit rating provides a basis for
determining the returns compared to the risk involved or perceived.
Higher the risk, higher the return. This could result in savings in cost
and optimisation of the funds costs.
(iii) Intermediaries: Investment and merchant bankers and other
market players use the rating for pricing, in placement and
marketing the issues,

Precautions of Credit Rating

1. Credit ratings are not recommendations to buy or sell or hold a

specified rated security nor are they offered as guarantees or
protections against default. They are opinions only.

2. Specific credit rating opinions are not intended to measure many

of the other factors that fixed-income investors must consider in
relation to risk-such as liquidity risk, pre-payment risk, interest rate
risk, risk of secondary market loss, or exchange loss risk.

3. The rating is specific to the instrument and is not the rating of the
issuer.
REFERENCES:

 Bagchi, S.K (2000) Credit Risk Management, India: Mc Graw Hill, page 1-14
 Varian H.R (1999) Risk Management, New York, Contosa Press, page 1-20
 RBI Guidelines (1999) Risk Management System in banks
 RBI Guidance notes on Credit Risk Management (2002)
 De Servigny, Arnaud and Olivier Renault (2004). The Standard & Poor's Guide to
Measuring and Managing Credit Risk. McGraw-Hill. ISBN 13 978-0071417556.
 Grewal, T.S (2002), India; Accounting Practices; Sultan Chand and Sons, page 41-68
 Kotler, Philip (2006) Marketing Management, Northwest University: Pearson Prentice
Hall
 1 JOSEPH C., 2006. Credit Risk Analysis: A tryst with strategic prudence. New Delhi:
Tata McGraw-Hill Publishing Company Limited
 . Gupta, S. (2003). Banking Industry Vision 2020. Mumbai
 Nandi, J. k., & Choudhary, N. K. (2011, May). Credit Risk Management of Loan Portfolios
by Indian Banks: Some Empirical Evidence. IUP Journal of Bank Management , 32-42.